I have made the case on a number of occasions that the Canadian real estate market, or at least parts of it, have been in a bubble. As someone who grew up in Saskatchewan, it was mind-boggling to me to see the prices of homes in Saskatoon - a city surrounded by prairie with -40C temperatures in the winter - double in two years such that Saskatoon became a more expensive city to buy a house than any city in the United States outside of the pacific coast, New York City and Boston.
I do not often agree with the columnist Murray Dobbin, and I am not sure if I agree entirely with the conclusions in this article, but relying on a report issued by the National Bank of Canada, Dobbin argues that Canada may not be as different as America as some Canadians think.
This, in my opinion, is a logical fallacy, not dissimilar to the arguments heard during the Tech Bubble, c1997-99. The fact that a market is different or has not collapsed does not mean it is so different and will not collapse.
US bank stocks did not appear to be in a bubble in 2006 based on any metric used - current earnings, forecasted earnings, book value, tangible book value, and so on. And they were not. But they were dangerous investments nonetheless because the assets that supported those valuations were overvalued.
Similarly, the Canadian housing market may not look like a bubble, but the structural foundations on which those home prices are based are probably flawed.
Let us review points of the broad economy of the past 10 years, which most economists either dismissed or ignored.
- A tech and stock market bubble formed in the 1990s.
- The Federal Reserve pumped large amounts of liquidity in the economy to save the world from the collapse of Long-Term Capital Management in 1998 and Y2K in 1999.
- Mainstream economists focus on inflation in prices paid. They do not focus on inflation in asset markets. In fact, many economists believe asset bubbles cannot happen, though fewer do so today than 10 years ago I would imagine.
- The stock market bubble collapsed.
- In response, the Federal Reserve cut interest rates to 1% and held rates at that level for a year.
- Monetary aggregates in the early part of the decade grew 20%+.
- Central banks around the world, particularly in Asia, begin buying dollars by the trillions to avoid currency appreciation, creating a flow of liquidity into global asset markets.
- Housing prices started to rise
- Wall Street ramped up securitization, creating all sorts of derivative products and off balance sheet structures, channeling more liquidity into the financial system
- Housing prices in many countries rose three, four and even five standard deviations above long-term trends and disconnect from other valuation metrics such as price relative to rent and affordability.
- Many economists said housing was not in a bubble, and that home prices were unlikely to fall much because they had not fallen since the Depression, including our esteemed Fed Chairman in testimony before Congress in 2006.
- Commodity prices exploded because 1.) Global structural supply/demand imbalances, 2.) liquidity created by central banks, and 3.) asset allocation decisions by large institutions such as pension funds. As it pertains to (2.) and (3.), oil goes to $147 a barrel even as demand is dropping and supply is rising. Commodity futures markets such as oil shift more so into contango. (Pension funds buy further out on the futures curve to take advantage of the "roll," whereby outer-dated contracts are cheaper in backwardation and "roll" up the curve to the spot price. Roll accounted for roughly two-thirds of commodity futures index returns from 1950 to 2000. Everyone trying to replicate this strategy created demand out on the curve, driving future prices up and shifting futures price curves into contango.)
- The housing bubble popped.
- The financial markets had their worst collapse since the 1930s.
- The economy plunged into arguably the worst crisis since the Great Depression.
- The Fed lowered the funds rate to 0% and is now supporting much of the credit markets. Government stimulus, including both monetary and fiscal policy, accounts for an unprecedented 30% of GDP.
- Asset markets, such as stocks and commodities bottom and begin to take off.
Now, let us put this into a Canadian perspective, with some unique Canadian facts.
- Canada fixed its fiscal problems in the mid-1990s, becoming arguably the best run developed country in the world after being perhaps one of the most fiscally irresponsible during the 1970s and 80s.
- The Canadian economy, which is heavily reliant on commodity prices, took off, particularly in western Canada. However, the strong loonie hit the manufacturing base of eastern Canada.
- Hedge funds became far more prominent in the financial markets. With the advent of technology, they searched the world to take advantage of arbitrage opportunities and carry trades. (A carry trade is when a fund borrows in a country with a lower interest rate and lends in another country with a higher interest rate.)
- Hedge funds and other financial institutions began to allocate more money to Canada because of the commodities boom and because of Canada's strong fiscal position. The Canadian dollar rose above par vis-a-vis the greenback and hit a multi-decade high.
- Liquidity flooded into Canada, driving up asset prices, including home prices.
- Canadian banks were not as reckless as American financial institutions. Banking is better regulated in Canada and banks hold more capital than their American counter-parts. Banking is essentially an oligopoly, with six banks accounting for about 80% of the market in the country.
- Because Canada's financial system is stronger, there was less forced selling of financial assets. A "death spiral" - whereby lower financial asset prices leads to impaired capital in the banking system, which leads to more selling, which leads to lower prices, which leads to more impaired capital, which leads to more selling, and so on - is fairly absent in Canadian fixed income markets.
- Therefore, Canadian housing prices fell less than their American counterparts as capital was not as constrained.
- Governments and central banks instituted enormous amounts of stimulus around the world, depreciating the value of fiat currencies and increasing the prices of real assets, including commodities. Stimulus in China was rammed through the financial system as banks were told by Beijing to lend, leading to stock piling of raw materials in China and higher commodity prices
- The Canadian economy is highly reliant on the United States. Roughly 40% of the Canadian economy is dependent upon exports, and 80% of Canadian exports go to the United States.
- The US government's and the Fed's actions are bearish for the US dollar. The US dollar becomes the currency to finance the global carry trade. The dollar began to fall and the loonie began to rise.
- In response, the Bank of Canada kept interest rates low to offset the weakness in the US and to avoid the loonie from rising too high against the greenback.
- Low interest rates spur borrowing for mortgages. Sales of Canadian homes reaccelerate. In some cities such as Vancouver, home sales over the past few months are breaking all-time highs.
Because both the Canadian financial system and Canadian fiscal policy are better run than in the United States, the fall-out in Canada has been less severe than in America. Canada is a beneficiary of global liquidity creation as it lowers Canadian interest rates and keeps commodity prices strong. This liquidity is being channeled into the Canadian housing market. Canada does not need as much stimulus as the rest of the world, but the global carry trade is channeling liquidity and capital into the country anyway, igniting the Canadian housing market once again.
This is very similar to what happened in the US housing market in the early part of this decade. In 2001-03 in Silicon Valley and Manhattan, even though thousands of people were being laid off in northern California and New York City from the fall-out from the tech bubble implosion, home prices rose. There was brief dip in home prices in Silicon Valley but the massive amounts of fiscal and monetary stimulation stabilized and buoyed housing markets across America. The Fed's policies at the beginning of the decade created vast secondary and tertiary unintended consequences, leading to the housing bubble.
Now, in the "New Economy," where asset prices are of the utmost importance, similar distortions are being created. The fact that home sales are breaking records in some Canadian cities does not reassure me. It frightens me. It tells me that we have merely delayed the inevitable and are setting up for possibly worse consequences down the road, as we did at the beginning of this decade.
There are structural reasons for higher asset prices in Canada. However, there are still enormous imbalances in the global economy, and Canada may now be more vulnerable than most countries to the massive global liquidity creation now occurring, given that the imbalances favour commodity-based economies.
We now live in an era where governments actively support asset markets. The enormous flood of liquidity and support by governments of asset markets is having secondary and tertiary unintended consequences, which are likely to be massive and have major ramifications in the future. The Canadian housing market is a major benefactor of The New Economy. The end-game is unlikely to be pretty.